Board governance and the connection to asset allocation

Well-governed boards have greater international diversification and lower cash holdings, according to a working paper by Carolina Salva and Nadège Bregnard from the University of Neuchâtel in Switzerland.

“Why would pension fund board governance shape asset allocations?” the paper asked. “In our view, asset allocations are potentially associated to board inefficiencies that can arise when board members are too busy, lack appropriate incentives or expertise in financial matters or, simply, favour their own interests. With the aim to favour their interests, limit engagement or protect themselves, we conjecture that boards will show higher levels of conservatism and will be holding more liquid assets.”

The researchers looked into this topic because they felt little is known about the role of pension fund governance in outcomes and asset allocation policy, which is an important driver of performance, says Salva.

“One of the most important decisions made by pension institutions is how much risk to take and in which assets to invest,” noted the paper. “This decision is critical because asset allocations are a key driver of performance and sustainability.”

Focusing on a sample of 210 Swiss pension funds between 2010 and 2012, the study reached the results by constructing a governance index that listed board attributes considered best practice and aggregating scores to try to measure the abstract concept of governance, says Salva. It then looked at this in relation to the pension funds’ asset allocations to find what attributes drive the relations discovered between asset allocation and governance.

“We identify, specifically, attributes that have to do with investment policy of pension funds that are more related to asset allocations,” she says.

The report’s main finding was that board governance is associated with asset allocation. More precisely, it found well-governed boards with established and comprehensive investment policies have greater international diversification, take more risk and have lower cash holdings, says Salva.

“Basically, we find that when pension funds put in place investment policies that address clearly the goals and provide adequate controls and benchmarks and performance measurement procedures, these pension funds do take more risk.”

While the researchers expected to find that well-governed funds take more judicious risk, Salva notes it was surprising to find that well-governed funds hold less cash. “If we think that cash holdings respond only to the operational needs of pension funds, we shouldn’t have found any assocation.”

This finding suggests other factors may explain why pension funds hold cash, she adds, but there isn’t much research to help understand this relationship.

“Clear goals, guidelines, tasks and controls mitigate the liability of trustees and the reputation threat to managers who then feel protected to take more risk,” the paper said. “As well, our results are also consistent with the greater financial expertise that is embedded in the process of developing and updating a comprehensive investment policy. Higher levels of expertise in financial matters brings confidence and expands risk-taking capacity while acknowledging the benefits of foreign diversification and the opportunity costs of holding excessive cash.”

Salva cautions the study is limited to Switzerland so the results may not hold in other settings. “Nevertheless, our results contribute to the debate on how pension organizations should evolve and what are the necessary conditions that should be put in place to promote sensible asset allocations and prudent risk-taking,” the paper said.